Excerpts from Ten Clues to Strong Stocks

source: www.kiplinger.com

There's no secret to picking good stocks -- all you need is the right information. Here are ten key measures that will point you to good stock buys, and all the numbers you need to crunch.

March 16, 2005

There's really no secret to picking good stocks. All you need is the right information and the know-how to use it.

Thanks to the Internet, the data are easy to find. So all you need to identify winning stocks, or know when to drop losers from your portfolio, is a grasp of the fundamentals -- the fundamental measurements of stock value and strength, that is.

There are literally thousands of stocks from which to choose. And they all fall into various categories: growth or value, small, medium or large companies. Each stock type can serve a different purpose in your investment strategy. But no matter what type of stock you seek, they all can be gauged using measurements.

In fact, many of the key ratios listed below. Keep in mind, though, that there's more to picking a stock than just good numbers. Products, management, competition and market forces should also be thoroughly researched. But by using the ratios below you can quickly separate the wheat from the chaff.

Bargain or premium?

No one wants to pay more for something than it's worth, and a stock is no exception. The adage "buy low and sell high" is good advice, but it doesn't refer only to a stock's price. You need to evaluate its underlying value to determine if it's a good deal.

The price-earnings ratio is one of the most widely-used measurements of a stock's value. This figure takes the price of the stock and divides it by its earnings-per-share (profits divided by number of shares) -- telling you how much an investor pays per share for the earnings, or profits, the company generates.

You should look not only at the previous year's earnings when calculating a P/E ratio, but also what analysts project the company will earn in future years. For example, if a company trades at $22 and earned 71 cents over the past 12 months, its trailing P/E is 31. If analysts expect it to earn 79 cents next year, its forward P/E is 28.

In general, the higher the P/E ratio, the faster and more consistently the market expects a company's earnings to rise. Larger P/Es can translate into more volatile investments because the lofty expectations have further to drop if the company falls short one quarter.

You can compare a stock's P/E ratio with the overall market or the average P/E of its industry. A P/E of 14, for example, may be high for an energy stock but low for a tech company.

And if your stock's P/E is unusually high, you might consider selling if you believe the company could have a hard time maintaining its lofty price. (Learn more about how value measures can signal when to sell your stock.)

Combining anticipated long-term earnings growth and P/E gives you a stock's price-earnings to growth or PEG ratio. It's figured by dividing a stock's P/E by analysts' projected earnings-per-share growth rate over the coming three to five years.

Stocks with relatively low PEG ratios may be bargains -- investors tend to favor those with PEGs below 1.

Looking at both the P/E and the PEG can give you a clearer picture of a stock's value. Just because Company A has a P/E of 20 and Company B's P/E is 32 doesn't necessarily mean the latter is overvalued. If analysts expect earnings to grow 10% annually at Company A and 30% at Company B, that gives them PEG ratios of 2 and 1.1 respectively, making Company B the better buy. A high P/E and a low PEG just means you're paying more to get more.

Beyond the P/E ratio

Many investors erroneously think that evaluating the P/E ratio is the best and only way to evaluate their holdings. Though easy-to-use, it is best utilized in context of other key figures. Often the P/E isn't the most effective method of evaluating a stock. What if, for example, the company you're interested in didn't make any money last year?

That's where other valuation measures, such as the price-sales ratio, come in handy. Often used to evaluate growth stocks, this ratio divides the stock's price by the company's annual sales per share. Lower is better, but the price-sales can vary widely among different industries, so it's best used when comparing stocks of similar companies. Combine it with our other fundamentals, and it goes even further to help you weed out the losers.

Say you're interested in a firm without earnings but it has a price-sales of 0.75 versus an average industry score of 2. It could be a bargain if the company can turn a profit soon, or if it's a new company in an up-and-coming industry where most of its peers aren't making money yet either.

But even if the company has earnings, don't overlook the price-sales. In fact, this figure can even be more accurate than a P/E ratio because sales are a lot harder for accountants to fudge than earnings. A low P/E but a high price-sales could signal one-time gains that are pumping up earnings per share.

The price-book ratio -- also known as the price-equity ratio -- is also useful for intra-industry comparisons. This measure takes the stock's price and divides it by the company's net assets (assets minus liabilities). Again, the lower this figure, the better the stock's value.

The price-book ratio works best when evaluating companies with a lot of assets, whether they are hard assets, such as machinery and inventory, or financial assets, such as those in a bank or insurance company. It doesn't mean much for tech firms where assets are more intellectual. Microsoft, for example, has an artificially high price-book because its intangible assets don't show up on its balance sheet.

You can also use the price-book ratio to evaluate foreign stocks. A P/E ratio, for example, could be impacted by different accounting rules overseas. But with the price-book ratio there is little room for confusion -- assets are assets.

Show me the money

Cash flow is one of the most popular fundamentals the pros use in evaluating a company's stock, yet few individual investors think twice about it. This figure is literally how much money is coming in and how much is going out. It provides a clear view of a firm's business -- perhaps more so than earnings -- especially when the company didn't make money.

Cash flow is also known as EBITDA -- earnings before interest, taxes, depreciation and amortization. Take out all those variables and you get at the guts of the business -- it eliminates secondary costs, non-cash charges and the impact of ever-changing tax law. This is particularly handy when looking at companies with large up-front capital expenditures, such as media stocks, because it helps investors find out how much the company is generating from operations, not how much its debt costs.

Look for positive cash flow and consistency.

Cash flow's first cousin is free cash flow. Take cash flow from operations minus the money needed to maintain the business. Free cash flow is money the company can use to expand its business, invest in new ventures and pay dividends.

If free cash flow runs negative, trouble looms.

Management efficiency

In sizing up your stocks, don't stop with determining their value. It's important to make sure a company's management is on track. A stock could look like a bargain but have problems at its core.

Evaluating a company's margins could clue you in to potential trouble down the road. Margins are a percentage of earnings to sales -- telling you how much a company squeezes out of its revenues.

For example, say ABC Corp. has a net income of $14 million on annual sales of $350 million. XYZ Inc. made $1.2 billion on annual sales of $45 billion. Comparing $14 million with $1.2 billion isn't very useful. But divide earnings by sales and you find out that ABC Corp. is more efficient -- it earned 4% on sales while XYZ earned 2.7%.

Steady or consistently rising margins are a sign of good management.

There are several types of margins, but each one follows the formula above. The difference comes in what expenses are factored in to your starting numbers.

For example, gross margins tell you how profitable the underlying business is by subtracting the cost of selling the company's goods. This includes marketing expenses, taxes and administrative costs.

Operating margins show how well management controls expenses by including sales costs in the calculation but excluding interest on debt, depreciation on equipment and other factors. In other words, to figure operating margins, you divide cash flow by sales. If management can keep costs down, its operating margins should hold fast or increase. Operating margins can also swell if a company raises prices without slowing sales.

Another way to measure management efficiency is to find out how much the company is getting out of its resources. Return on equity does that by dividing net income by stockholders' equity.

For example, a 20% ROE means the company made 20 cents on every dollar invested.

The bigger the ROE the better. A trend of rising ROE shows management has become increasingly efficient at investing the shareholders' stake in the company.

Be sure you compare annual figures or comparable quarters when calculating this number. Some companies, such as retailers, pull in greater income during certain seasons. For example, ROE at Toys R Us in the fourth quarter tends to skew higher than in the first quarter due to increased holiday sales.

When looking at ROE, you should also check out a firm's debt-to-equity ratio -- long-term debt divided by shareholders' equity. This figure shows how efficiently management uses borrowed money to increase returns for shareholders.

If it looks like the company is maintaining its ROE simply by taking on more debt, that's a red flag. While borrowed money can help companies grow faster, too much debt, particularly during an economic slowdown, can cripple a company's earnings or even send it into bankruptcy. High debt levels can sometimes be inevitable in certain industries such as airlines and utilities. But low debt often gives a company a competitive edge.